The SFC Lehman Minibond Report and Banks' Responsibility

Here is our comments on the“SFC Lehman Brothers Minibonds Incident Report".

We request Legco Lehman Incident Investigation Committee to investigation issues and questions presented here to SFC officer, Banks and HKMA officer during the committee's investigation.

The key issue with the Minibond is not about if it declared “it is principal protected”. The key issue is about the misrepresentation and omission of the true nature and risk of the so-called “Minibond”. If a person bought a share of HSBC, and later found out that he actually owned an option related to HSBC stock price. Can the seller claim its innocence because the “option document declared that it is not principal protected”?

- (a) The Report failed to identify the fact that many (if not all) Minibond Prospectuses had consistently given misleading information, omitted material risk in the following aspects: credit linked with 7 reference entities or credit linked with 7+MANY (over 100) reference entities; Synthetic CDO criteria and risk;

- (b) The Report failed to identify the fact that banks did not provide minibond buyers with complete information, i.e. banks did not make adequate disclosure of relevant material information about minibond.- (d) The Report faile to identify that Banks’ due diligence was at faulty (to say the least).

- (c) The Report's obversation in Section 16.3.1 and 16.3.2 was inadequate. The The Report's Section 16.4 did not reveal the understanding of banks staff which is one of key issues associated with Minibond Sales.

It is not uncommon for banks to find all the possible loophole even lame excuse to protect their own interest. The Government must try its very best to protect the public's interest, especially when public does not have much legal way to challenge banks. The Government should not join banks in finding all possible loophole and excuses to hide the truth of minibond sales, while in the name of for the best interest of Hong Kong as Financial Center. When banks made mistakes, the damage could be over billions of dollars, the damage could affect possibly tens of thousands family in Hong Kong, the damage would shock people’s trust on banks and affect banks’ image to the world. A thorough investigation on the minibond sales is also to protect the Hong Kong's reputation as a financial center in the long term.

1. A few extract from the Report.
- In the Section “2.2. Regulatory Structure”, it states “2.2.1. (...) disclosure and suitability. The first of these is the responsibility of SFC - to ensure that, based on the information provided by the product issuer, sufficient information is disclosed in the product documentation by the issuer to enable a reasonable person to make an informed decision. “.
Can we assume that ‘a reasonable person’ here refers to persons who are not credit derivative product experts such as 黃元山，迷宗?

- As reported in the news,
“證監會行政總裁韋奕禮表示、證監會角色並非要監察投資產品價格是否穩定、而是要確保所批核之投資產品，有全面市場披露”

- SFC’s William Pearson said “ (……) We are seeing more complicated products come on to the scene, but I think as long as the disclosure is clear, accurate and not misleading, we will be happy to see that carry on”, as in the Asian Structured Products Review 2005, (http://www.pacificprospect.com/downloads/asian_structured_products_review.pdf

2. Minibond Series #19, #21-#23, and #25-#36 have Synthetic CDO as collateral. Some earlier series (#12, #15-#18) probably have Synthetic CDO collateral too.

The Prospectuses Misled on Credit-Linked to 7 Reference Entities

3. The Prospectuses prominently stated that minibond was credit linked with 7 well-known reference entities. A Synthetic CDO consists of CDS with MANY other entities. By choosing Synthetic CDO as minibond collateral, it means that minibond’s value is also decided by the credit risk of its collateral’s portfolio holding. The prospectuses never clearly stated the fact that the Minibond is in fact credit linked with “7 plus MANY Other (undisclosed)” reference entities The prospectuses failed to discloses where the risks truly lie, failed to meet SFC’s “Clear, Accurate, No misleading” requirement.

The Report quoted the declaration of “not principal protected” in “16.3.1”. But the Report failed to notice the fact that the Prospectus (page 9) stated “Are our Notes principal protected? Our Notes are not principal protected: if a credit event happens to any one of the 7 reference entities before the maturity date, you will lose part, and possibly all, of your investment.”. As a consequence, the prospectus successfully let retail clients into believing that to believe that the prominent “Credit linked with 7 reference entities” was the condition for the “not principal protected”. In other words, the minibond’s principal would be protected if there is no credit event happened to the 7 (not “7+MANY OTHER”) reference entities. Responsible banks staff also confirmed the above understanding, either due to their lack of knowledge on the true nature and risk of the minibond, or out of fraudulent intention.


4. The Report quoted “16.3.2. Our Notes are not suitable for everyone…..Before appl ying for any of our Notes, you should consider whether our Notes are sui tabl e for you in light of your own financial circumstances and investment objectives. If you are in any doubt , get independent professional advice.”, in defending the Prospectuses.
However, the Report failed to notice the statement made by the prospectuses in the page 10 of Series #27, Section “Who should buy our Notes? Are they suitable for everyone?” This Section started with “Our Notes are not suitable for everyone” the wile card statement, but followed up with a specific condition:
“Our Notes are only suitable for investors who are: (….)
confident that none of the 7 named reference entities will be affected by a credit event (….)”, to stress the confidence to the 7 reference entities. That is, if if you are confident on the 7 reference entities, the Notes is for you.

This was obviously misleading. A potential Minibond investor would mistakenly think that all the risk of the minibond is from the 7 reference entities.

As a result, many retail clients thought the risk of credit-event of the 7 reference entities could be tolerated, for the long lock up 4-7 years period. But, was the minibond really about “credit-linked to the 7 reference entities”? Was the minibond money invested into any real assets associated with the 7 reference entities?

The Prospectuses Failed to Explain How The Minibond Money Was Invested

5. The Prospectuses never clearly stated the fact that: An investor in the Minibond does not lend money directly or indirectly to the 7 reference entities or any of the undisclosed MANY reference entities that comprised of the minibond synthetic CDO collateral. It only stated “We use the money which you invest in our Notes to buy a package of assets.” (page 19, “What happens to my money? How can Pacific International Finance Limited pay me back?”).
A prospectus must reveal where the money will be invested into and where the interest and repayment of the principal will be coming from. The brand name of minibond and the credit linked to 7 reference entity gave retail clients false illusion that the money would be invested into debt/loans of the reference entities.

When we received call from our bank after Lehman filed for bankruptcy, many of us thought it would not be a big issue because the credit linked company were okay and the 7 companies should be able to pay their interest and repay the principal in the future.

For your information, the Prospectuses listed Definitions on many financial terms, such as “bond”, “loan”, “obligation”, many more on the credit rating and the 7 reference entities credit rating. But it never lists “CDO” / “Synthetic CDO”.

The Prospectuses Failed to Disclose Collateral’s Reference Entities' Criteria

6. A Synthetic CDO collateral is comprised of CDS with totally unknown number of reference entities, usually with the lower-rated tranches bearing more of the risk than the higher-rated tranches. A AAA-rated Synthetic CDO usually consists of tranches with debt at rating category varying from AAA to CCC.

Plenty of credit rating information on the 7 reference entities was disclosed. But there was no credit rating information disclosed on the reference entities that comprised of the synthetic COD of the minibond collateral.

The Prospectuses should be at least able to disclose criteria range or guideline on the criteria for selection of the reference entities. Such disclosure would help readers to assess the average portfolio credit quality and the possibility of default event in the portfolio, e.g.:
-number of reference entities or the number range;
-the portfolio credit rating distribution ratio; e.g. how many /if any entities will be below CCC; how many will be between BBB/BB or below BB-; etc.
-the intended portfolio's industry concentration rate.

The Prospectuses Failed to Disclose the Collateral's Default Event Impact

7. A Synthetic CDO could experience 100% principal loss with less than 5%-10% default event in its portfolio reference entities. The default event impact to the principal loss was never mentioned in the Prospectuses.
There was no mentioning on the impact of default event to related principal loss, e.g. 7th default->100% principal loss, out of 100 reference entities.

The Prospectuses obviously did not provide “sufficient information” as stated in SFC’s report. The prospectuses obviously did not meet SFC’s “Clear, Accurate and non misleading” requirement either. Instead, the prospectuses consistently omitted material fact and gave misleading statement, so that a reasonable person would not be properly informed of the true nature and risk of the Minibond.

Banks Provided Minibond Buyers with Incomplete Information

8. SFC failed to notice the fact that banks did not provide clients with all the minibond relavant information. “The Minibonds are secured collateral and swap” as defined by The Report “16.2”. The CDO collateral information thus held the most important details on the Minibond, because the collateral was not a conventional AAA-rated bond. The dimished collateral value also proved the criticialness of such collateral information. The prospectuses were only part of the minibond information. With the collateral information, Minibond buyers would have a (2nd) chance to have a look at what was really in the minibond, and thus to assess the true nature and risk of the Minibond, especially when banks failed in their due diligence.

Detailed Information about the collateral, including evidence of the rating and the terms and conditions of the collateral, usually would be available prior to the issue date. Banks should have requested after offer closed. Banks should have sent such CDO collateral information documents /or notice of such documents’ availability to minibond purchasers. Banks are required to disclose relevant material information to clients.

Bank’s Due Diligence Was at Faulty

9. Banks should have cautioned their clients about the risk related to the Synthetic CDO collateral. Banks should also have requested the minibond issuer to disclose related CDS information (e.g. CDS reference entities name and credit rating, percentage of portfolio held in each credit rating category, the relationship of reference entities' default rate to the consequent principal loss percentage, etc.). We contend that, instead of exercising due diligence, the Bank in fact collaborated, we would suggest fraudulently, with the minibond issuer, hiding the risk of the Synthetic CDO from the bank's retail clients, with the objective of increasing the sale of the minibonds.
- It was never pointed out to us that the minibond was not invested into any debt / loans / bonds issued by any of the 7 reference entities and that the minibond's underlying collateral CDO's key asset was CDS with many entities.
- It was never mentioned or explained to us that a "AAA-rated CDO" or "AAA-rated Synthetic CDO" was not the same as a "AAA-rated" bond. It was never explained to us what was a “AAA-rated CDO” or “AAA-rated Synthetic CDO”. It was never explained to us what a CDO is comprised of and what kind of risk a CDO may have.
- It was never mentioned or explained to us that a "AAA-rated Synthetic CDO" may not invest into any debt/loan/bond at all. Nor that a AAA-rated Synthetic CDO usually consists of tranches with debt at various rating categories from AAA to CCC.
- We were never told that the most important feature of a synthetic CDO is the tranching of credit risk.
- We were never told that the Synthetic CDO's value is decided by the credit risk of its portfolio holding. Nor that the minibond's collateral would consist of CDS with many entities which could be in various rating categories from AAA to CCC.
- It was never mentioned or explained to us that a “AAA-rated Synthetic CDO” could have an average portfolio credit quality at BBB/BBB-.
- We were never told to be aware that the minibond was, in fact, not only credit-linked with the 7 reference entities, but also credit-linked with many other entities.
- We were never told that there was no detailed information being provided on the Synthetic CDO's CDS entities & entities' credit rating, no information regarding the Synthetic CDO portfolio's industry concentration percentage, no information on the impact of the number of default event of portfolio to the principal loss (e.g. 5%-10% default event could result in 100% principal loss, etc.). We were never told that the minibond's value would be greatly affected by the default event of underlying Synthetic CDO's CDS entities.
- And we were never told that the default event or the credit rating change of all the entities included in the CDS of Synthetic CDO collateral is critical to the value of the minibond collateral.

Banks and Banks staff Breaching Code of Conduct ?


10. The Report wrote “16.4” listed a few risk mentioned in the Prospectuses.
- (10.1) Did the SFC ever check how many banks staffs were actually aware of all the risk listed in the “16.4” and explained all of them to their clients at the point of sale, other than the credit-event of the 7 reference entities and no liquidity / long lockup period?
- (10.2) The Report wrote “2.3.1 "..... Intermediaries were still under an obligation pursuant to the Code of Conduct to explain the nature and risks of the product they were selling and ensure it was suitable". Does SFC consider that giving “the credit-event of the 7 reference entities and no liquidity / long lockup period” would be sufficient for briefing clients on the true nature and risk of Minibond?
- (10.3) The Report wrote “2.5.2. The Code of Conduct also imposes obligation on intermediaries to ensure their staff are properly trained and supervised”. What was SFC’s finding on this?
- (10.4) Should banks / banks staff’s Honesty and Fairess, Care to their Clients be defined as:
"For a complex credit derivative product like the minibond, the responsibility of Bank's sale staff is limited to: passing the Issuer Prospectus to the client when being requested, and to tell the minimum information to clients, even if the minimum information could be misrepresenting and misleading on the full picture of the product”?
- (10.5) Although Minibond holders signed the minibond purchase form which has one item as “confirmed to have received Issuer Prospectus and Secured Continuously Offered Note Programme”. Most (if not all) minibond holders received the Issuer Prospectus only (if they received any prosectus), had not received the Secured Continuously Offered Note Programme at all. As a matter of fact, banks staff did not mention the Secured Continuously Offered Note Programme to most (if not all) of the minibond buyer

contact: minibondVictim@gmail.com